28 September 2017
Crisis? What crisis?
Heavyweight commentators offer portents of gloom.
By Frank O’Nomics
Looking at the current stance of the key central banks it would seem fair to assume that the global economy is in reasonable shape. Fears of continued disinflation, or even deflation, seem to have faded with the Fed looking to start unwinding quantitative easing (having already started a programmes of rate rises), the Bank of England acknowledging that UK rates will soon have to rise, and even the ECB turning distinctly less dovish. The withdrawal of emergency policy measures should give reassurance that the economic recovery is viewed as robust. Why then have the likes of Deutsche Bank and Noble laureate Robert Shiller started to ask questions regarding the likelihood of a financial crisis and a bear market?
Let’s first look at the potential triggers for a financial crisis. Deutsche has come up with a long list. The biggest danger would seem to be that of a recession. Given that most monetary policy tools have already been exhausted, there may be little room to provide further help. In some respects the tightening moves currently discussed may be an important means of rebuilding some scope to ease policy later. The chances of a recession, given the extreme level of both central bank and household indebtedness, are quite high. Deutsche’s long-term assets survey points out that in the last decade the extra money printed, together with the widening of government budget deficits, has produced a global stimulus of $34trn. Given such an unprecedented stimulus generated by borrowing, it may only take a modest rise in interest rates to prompt a banking collapse as bad debts rise. The scenario where prices start to fall again is no better, as this will raise the real value of the debt and could lead to a sharp fall in asset prices. Where might the problems start? In Europe the situation is most acute in places like Italy, where debt is high, the banking system is particularly weak, and the country faces extreme uncertainty ahead of elections next year. Globally, China is the biggest threat, with debt having quadrupled to $28trn since the financial crisis. The IMF recently expressed concerns at China’s credit driven growth strategy, pointing out that private sector debt to GDP was running at 175%, an 80% rise since 2008 – a level that they say is “associated with sharp growth slowdowns and often financial crises”. The Chinese economy is now so intertwined with the West that any crisis there would rapidly become global.
The timing of such gloomy research, based on empirical evidence, is not unreasonable. In the US, since 1950, 13 rate-tightening cycles have been followed by a recession. A recession does not always involve a bear market in equities, depending on what your definition of a bear market is. Hence the worry may be more for jobs than for our investments. However, if we regard a bear market as a 20% fall in a relatively short space of time, the US has experienced 13 (that number again) since 1871. We need to ask then, if a coming recession would this time result in a bear market. Shiller’s analysis looks at those previous 13 bear markets to try to detect similarities with the situation currently faced, and in particular the level of stock market valuations prior to them. Some years ago he developed a measure known as CAPE (cyclically-adjusted price earnings ratio). The current CAPE ratio, at just over 30, is very high indeed, given that the long-term average is 16.8. It has only been higher than 30 in 1929 (ahead of the Wall Street Crash) and 1997-2002 (the dot com bubble). Price earnings ratios in the tech sector are now back to the levels seen in the dot com era. Some justification for the high level of stock valuations can be found in the level of real earnings growth being reported by the corporate sector, which has been running at 13.2% in the US, well above the long-term average of 1.8%. However, Shiller points out that such peaks in real earnings growth occurred just before all of the 13 bear markets. We might look for some reassurance from the low level of volatility. The current standard deviation of monthly changes in real stock prices is just 1.2%, only one third of the historic average, but again this market complacency is seen as typical ahead of a bear market.
Is it all gloom and doom? Not necessarily. The timing of any financial crisis, accompanied by a bear market, is very hard to predict. The dot com bubble lasted several years and those who opted out early missed some decent returns. There is no reason why a period of recovery cannot go beyond a certain time. Many would argue that it is the amount of economic slack that exists that will dictate the length of the recovery and that the global output gap still suggests a lot of scope. The point is that it is impossible to predict the exact peak of a market and, if there is strong evidence that there could be another financial crisis, and an attendant bear market, it may not be too early to start to adopt a more defensive approach. There are some signs that UK households are becoming aware of the dangers. UK consumer credit growth is slowing, albeit from a very high level, as household spending starts to fall. Similarly there has been a very high level of demand to remortgage (10% up on last year) as people rush to insulate their finances from rate rises. This behaviour may reduce the chances or the impact of a financial crisis, but is hardly a recipe for economic growth. Tightening one’s belt is one thing, but restructuring your savings is another and, particularly if interest rates are to rise, holding a greater proportion in cash may make sense. The dangers of a bear market for asset classes such as property and equities look very real.
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